Spicing Your Portfolio With Small-Cap REITs

TheStreet.com

NEW YORK (TheStreet) -- It's not surprising many of the large real estate investment trusts fell victim to the latest sell-off in dividend stocks triggered by rise in Treasuries.

It's also not surprising to see the dominant index-driven large-cap REITs absorbed most of the decline in value, while the small-cap REITs managed to fly under the radar.

The tradeoff for investing in large-cap stocks can be easily traced back to the institutional buyers - led by exchange-traded funds and mutual funds -- that have a higher degree of analyst coverage and much lower risk tolerances. Conversely, the small-cap REITs lack the same Wall Street coverage and investor interest can result in shares remaining undervalued -- especially in down markets -- for extended periods of time.

So these under-analyzed small-cap REITs flying under the radar can offer better potential for growth over the long term. Due to decreased institutional support, there's a better chance that small-cap REITs will have lower valuations that result in an underestimation of a company's operational health and prospects for growth.

In my Intelligent REIT Investor newsletter I offer investors two different portfolio options:

  • Swan Portfolio: A conservative REIT portfolio aimed to benefit the investor looking to harness the power of repeatable dividend income. Although growth is an important aspect to intelligent investing, my "sleep well at night" (aka SWAN) portfolio is rooted in principal preservation and durable and safe dividend income.
  • Salsa Portfolio: The second portfolio option is the Salsa portfolio and, as the name describes, it includes a few ingredients that help spice up the portfolio to deliver higher growth (than the Swan portfolio) with less focus on dividend safety and more focus on total returns.

I model my Salsa portfolio with REITs that are complementary. Although certain REITs are considered more risky than others, the essential element is bigger gains and lower valuations. In such, I maintain between 10% to 25% of my Salsa portfolio in small-cap REITs.

Collectively, small-cap REITs have always been seen as more risky bets than large-caps, and although they don't have the diverse revenue streams or stable cash flows as the big boys, they are complementary to my overall Salsa growth model. As a key ingredient for the Salsa portfolio, the small-cap REITs create a buoy effect as they are more susceptible to wide swings (by Mr. Market) in price due to lower trading volumes -- a key attribute since greater volatility deters action and often invites selling.

The key for any REIT portfolio is diversification. Whether you are a Swan investor or a Salsa investor, I cannot over estimate the importance of practicing diversification.

The legendary Ben Graham taught that a fundamental principle of investing is that, over time, diversification is the key to stability of performance and preservation of capital. You might have outstanding results if you put a huge portion of your assets in one stock, but nobody can foretell the future. Occasionally even Warren Buffett has zigged when he should have zagged, and real estate has, in the past, been a somewhat cyclical investment.

The list of 10 small-cap REITs below consists of a variety of equity REITs and the combined market capitalization for these REITs is just over $5 billion. To put that into perspective, the entire U.S. equity REIT universe is around $600 billion, according to : NAREIT, and these 10 small-cap REITs represents less than 1% of the U.S. equity REIT universe.

The 10 are: Whitestone REIT, UMH, Agree Realty, Excel Trust, AmREIT, Monmouth Real Estate, Gramercy Property Trust, Investors Real Estate, Silver Bay Realty Trust and Retail Opportunity Investment Corp..

REITs continue to be more widely utilized by an increasingly broader investor base as part of an overall "growth and income" strategy, as opposed to income only. Accordingly, many equity REITs are trading at premium valuations and prudent investors should consider the smaller cap REITs that are often overlooked by the Wall Street analysts.

Benjamin Graham always tried to buy stocks that were trading at a discount to their net current asset value, oftentimes the ones being ignored by Wall Street and the investing public for no good reason in spite of stellar results. In other words, Graham would buy stocks that were undervalued and hold them until they became fully valued.

As he wrote in "The Intelligent Investor" (in 1949):

"The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades, an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realized by the passive investor."

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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